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Peru - The Economy


THE PERUVIAN ECONOMY achieved a higher rate of economic growth than the average for Latin America from 1950 to 1965, but since then has turned from one of the more dynamic to one of the most deeply troubled economies in the region. Even in the period of rapid growth, Peru was characterized by exceptionally high degrees of poverty and inequality, and since the late 1980s poverty has become much worse. Major changes in economic strategy introduced in 1990 and 1991 offer new hope for future growth but have not been oriented toward reduction of poverty and inequality.

In the first post-World War II decades, Peru achieved an above-average rate of growth with low levels of inflation and with rising exports of its diversified primary products. Output per capita grew 2.9 percent a year in the decade of the 1950s and then 3.2 percent annually in the first half of the 1960s, compared with the regional growth rate of 2.0 percent for these fifteen years. As of 1960, income per capita was 17 percent above the median for Latin American countries. However, since the mid1960s the economy has run into increasing difficulties. Output per capita failed to grow at all from 1965 to 1988, then fell below its 1965 level in 1989 and 1990. The previously moderate rate of inflation accelerated, balance of payments deficits became a chronic problem, and the country accumulated a deep external debt. As poverty worsened, political violence in the countryside and cities grew increasingly intense. The economy and the society as a whole seemed to lose coherence and any sense of direction.

The reasons for this deterioration from 1965 to 1991 are complex and very much open to debate. Many aspects of the debate center on two opposing conceptions of what national economic strategy and goals should be. One conviction is that the best course is to keep the economic system open to foreign trade and investment, to avoid extensive government intervention in the economy, and to rely mainly on private enterprise for basic decisions on production and investment. The contrary conception favors restricting foreign trade and investment while promoting an active government role in the economy to accelerate industrialization, to reduce inequality, and to control the actions of private investors. The conflict between these economic models is familiar in the experience of all Latin American countries. The failure to reconcile them in Peru has been an important factor in the deteriorating economic performance since the mid-1960s.

At least five interacting problems have been important in the explanation of why the economy has deteriorated so badly since the mid-1960s. First, natural resource limits began to handicap further expansion of primary product exports, requiring difficult changes in the structures of production and trade. Second, partly in response to these constraints, and partly as a matter of a growing conviction that the country needed to industrialize more rapidly, successive governments began to promote industrialization through protection against imports, reversing the country's traditional policy of relatively open trade. Third, dissatisfaction with widespread inequality and poverty encouraged attempts at radical social change, but the two governments that tried to lead the way--those of General Juan Velasco Alvarado (1968-75) and Alan García Pérez (1985-90)--failed to find any effective answers or to maintain viable macroeconomic policies. Fourth, the temporary move back toward a more open economy under the second government of Fernando Belaúnde Terry (1980-85) resulted in a surge of imports and an external crisis--mainly because of currency overvaluation and an excessively rapid rise of government spending--that again discredited this approach. And finally, rural violence took on a profoundly destructive character with the growth of the Shining Path (Sendero Luminoso-- SL) and the cocaine industry. On top of those two sources of violence, weakening governmental capability to maintain order and worsening conditions of employment led to growing security problems in cities.

Deteriorating conditions since the mid-1960s need to be considered against the background of a deeply divided society and a considerable lag, compared with many other Latin American countries, in developing either a competitive industrial sector or a modern structure of public administration able to implement public policies effectively. These handicaps can be overstated. After all, the Peruvian economy functioned well up to the mid1960s , and both private business and government officials have gained experience since then. As of the beginning of the 1990s, however, the country's prolonged decline had seriously undermined public confidence in the possibilities for recuperation and renewed growth.

The most evident symptoms of the crisis at the beginning of the 1990s were falling national output and income, high levels of unemployment and underemployment, worsening poverty and violence, accelerating inflation, and deep external debt. Under the Belaúnde administration, the external debt grew too high for Peru to meet scheduled service payments, although the government maintained the position that payments would be resumed when possible. Under the next government, García made a point of declaring that payments would be unilaterally limited to 10 percent of export earnings. His more aggressive position led to a near-total cutoff of external credit, which remained in effect throughout his term.

The government of Alberto K. Fujimori (1990- ) adopted a drastic stabilization program to break out of this complex of problems by first attacking the forces driving inflation. The initial shock of the new measures, which more than doubled the consumer price level in a single day, nearly paralyzed markets and production. After a steep fall in output, the economy began to stabilize with a lower rate of inflation but without any strong signs of recovery. Although the Fujimori program included many lines of intended action beyond the initial shock, it remained incomplete in many respects. It raised a host of questions about what other policies would reactivate the economy while preventing any further burst of inflation, and how long it would take to restore something like Peru's earlier capacity for growth.


Peru - History of the Economy


Through the nineteenth century and into the mid-twentieth century, the great majority of the Peruvian population depended on agriculture and lived in the countryside. By 1876 Lima was the only Peruvian city with over 100,000 people--only 4 percent of the population. Much of the impetus for economic growth came from primary exports. In common with the rest of Latin America up to the 1930s, Peru maintained an open economic system with little government intervention and few restrictions on either imports or foreign investment. Such investment became highly important in the twentieth century, especially in the extraction of raw materials for export.

For many Latin American countries, the impact of falling export prices and curtailed external credit in the Great Depression of the 1930s led to fundamental changes in economic policies. Many governments began to raise protection against imports in order to stimulate domestic industry and to take more active roles in shaping economic change. But Peru held back from this common move and kept on with a relatively open economy. That put it behind many other countries in post-World War II industrialization and led to increasing pressures for change. Significant protection started in the 1960s, accompanied by both new restrictions on foreign investment and a more active role of government in the economy.

One of the country's basic problems has been that the growth of population in the twentieth century outran the capability to use labor productively. The ratio of arable land to population-- much lower than the average for Latin America--continued decreasing through the 1970s. Employment in the modern manufacturing sector did not grow fast enough to keep up with the growth of the labor force, let alone provide enough opportunities for people moving out of rural poverty to seek urban employment. The manufacturing sector's employment as a share of the labor force fell from 13 percent in 1950 to 10 percent in 1990.

Orientation Toward Primary Product Exports

Peru's most famous exports have been gold, silver, and guano. Its gold was taken out on a large scale by the Spanish for many years following the conquest and is of little significance now, but silver remains an important export. Guano served as Europe's most important fertilizer in the mid-nineteenth century and made Peru for a time the largest Latin American exporter to Europe. The guano boom ran out about 1870, after generating a long period of exceptional economic growth. When the guano boom ended, the economy retreated temporarily but then recovered with two new directions for expansion. One was a new set of primary product exports and the other a turn toward more industrial production for the domestic market.

The alternative primary exports that initially replaced guano included silver, cotton, rubber, sugar, and lead. As of 1890, silver provided 33 percent of all export earnings, sugar 28 percent, and cotton, rubber, and wool collectively 37 percent. Copper became important at the beginning of the twentieth century, followed on a smaller scale by petroleum after 1915. Then, in the post-World War II period, fish meal from anchovies caught off the Peruvian coast became yet another highly valuable primary product export. Industrial products remained notably absent from Peru's list of exports until the 1970s. As late as 1960, manufactured goods were only 1 percent of total exports.

Manufacturing for the home market has had many ups and downs. The first major downturn came with the guano boom of the mid- nineteenth century. Foreign-exchange earnings from guano exports became so abundant and, therefore, imported goods so cheap that much of Peru's small-scale local industry went out of production. The end of the guano boom relieved this pressure, and in the 1890s a new factor, a prolonged depreciation of the currency, came into play to stimulate manufacturing. The currency was at that time based on silver, and falling world market prices for silver in this period acted to raise both import prices and export values (of products other than silver), relative to Peruvian costs of production. Without any overt change in national policies, Peru began a process of import-substitution industrialization combined with stronger incentives for exports. Domestic entrepreneurs responded successfully, and the economy began to show promising signs of more diversified and autonomous growth.

This redirection of Peruvian development was in turn sidetracked in the 1900-1930 period, in part by a decision to abandon the silver-based currency and adopt the gold standard instead. The change was intended to make the currency more stable and, in particular, to remove the inflationary effect of depreciation. The change succeeded in making the currency more stable and to some degree in holding down inflation, but Peruvian costs and prices nevertheless rose gradually relative to external prices. That trend hurt exports and the trade balance, especially in the 1920s, but instead of devaluing the currency to correct the country's weakening competitive position, the government chose to borrow abroad to keep up its value.

As has been noted, many Latin American countries reacted to the Great Depression by imposing extensive import restrictions and by adopting more activist government policies to promote industrialization. But at that point, Peru departed from the common pattern by rejecting the trend toward protection and intervention. After a brief experience with populist-style controls from 1945 to 1948, Peru returned to the open economy model and a basically conservative style of internal economic management, in sharp contrast to the growing emphasis on import substitution and government control in Argentina, Brazil, Chile, and Colombia.

Aided by the early recovery of some of its main exports in the 1930s, and then by development of new primary exports in the early post-World War II period, Peru had in many respects the most successful economy in Latin America up to the mid-1960s. But increasing pressure on the land from a rapidly growing population, accompanied by rising costs and limited supplies of some of the country's natural resources, began to intensify demands for change. One of the worst blows for continued reliance on growth of primary exports was a sudden drop in the fish catch that provided supplies for Peru's important fish meal exports; over-fishing plus adverse changes in the ocean currents off Peru cut supplies drastically in the early 1970s. That reversal coincided with supply problems in copper mining. Costs had begun to rise steeply in the older mines, and development of new projects required such large- scale investment that the foreign companies dominant in copper hesitated to go ahead with them. Further, population pressure and increasing difficulties in raising output of food converted Peru into an importer for a rising share of its food supply and began to work against use of land for agricultural exports. Although new investment and better agricultural techniques could presumably have helped a great deal, it began to seem likely that the only way to maintain high rates of growth would be to shift the structure of the economy more toward the industrial sector. Evolution of Foreign Investment

During its long period of attachment to an open economic system, Peru welcomed foreign investment and in some periods adopted tax laws specifically designed to encourage it. That is to say, until the 1960s the small fraction of Peruvians in a position to determine the country's economic policies welcomed foreign investment without paying much attention to growing signs of popular opposition. In the 1960s, many things changed. The major change for foreign investors was that growing criticism of their role in the economy led to nationalization of several of the largest firms and to much more restrictive legislation.

Foreign investment played a relatively minor role in the nineteenth century, although it included railroads, British interests in banking and oil, and United States participation in sugar production and exports. Its role grew rapidly in the twentieth century, concentrated especially in export fields. In 1901, just as Peruvian copper began to gain importance, United States firms entered and began buying up all but the smallest of the country's copper mines. The International Petroleum Company (IPC), a Canadian subsidiary of Standard Oil of New Jersey, established domination of oil production by 1914 through purchase of the restricted rights needed to work the main oil fields. The trend to foreign entry in manufacturing as well as finance and mining was stimulated by promotional legislation under the eleven-year government of Augusto B. Leguía y Salcedo (1908-12, 1919-30), an initially elected president turned dictator who regarded foreign investment as the key to modernization of Peru. That much-publicized partnership between a repressive government and foreign investors was to play an important role for the future of Peru, by feeding convictions that foreign investment was inescapably linked to control of the country by the few at the expense of the public.

By the end of the 1920s, foreign firms accounted for over 60 percent of Peru's exports. The Great Depression of the 1930s changed that by bringing new foreign investment to a halt and by driving down the prices of the products of foreign firms (chiefly copper) much further than those exported by Peruvian firms. That double effect brought the share of exports by foreign firms down to about 30 percent by the end of the 1940s. Foreign investment remained low in the first postwar years, both because investors in the industrialized countries were preoccupied at home and because it was not encouraged by the populist government in Peru from 1945 to 1948. After a military coup installed a conservative dictator in 1948, the government offered a renewed welcome to foreign investors, made particularly effective by the Mining Code of 1950. This law offered very favorable tax provisions and quickly led to an upsurge of new investment. History repeated itself: as in the 1920s, a repressive government turned to foreign investors for economic growth and for its own support, adding fuel to widespread public distrust of foreign firms.

Public opposition to foreign ownership focused particularly on the largest firms owning and exporting natural resources, above all in copper and petroleum. The IPC became the center of increasing conflict over the terms of its operating rights and its financial support of conservative governments. When Belaúnde (1963-68, 1980-85) took office as president in 1963, he promised to reopen negotiations over the contract with IPC, but he then delayed the question for years and finally backed away from this promise in 1968. His failure to act provoked the military coup led by General Velasco, this time from the left wing. The Velasco government promptly nationalized IPC and started a determined campaign to restrict foreign investment. Although the government subsequently moderated its hostility to foreign firms, continuing disputes and then the deterioration of the economy led some companies to withdraw and held foreign investment down to very low levels through the 1980s.

The redirection of economic strategy under the Fujimori government in 1990-91 included a return to welcoming conditions for foreign investment, providing a much more favorable legal context, and disavowing completely the control-oriented policies of the governments of Velasco and García. Several foreign oil companies responded immediately, although the disorganized state of the economy and the context of political violence discouraged any general inflow of new foreign investment.


Peru - Agriculture


Perhaps the most important fact about the agricultural sector is that its production has not kept up with the growth of population. Total output of agriculture and fishing combined rose 63 percent between 1965 and 1988, but output per capita fell by 11 percent. Output per capita started falling in the early 1950s, climbed back up again to its 1950 level by 1970, then began a more pronounced and prolonged fall through the 1980s. Per capita output of food, as distinct from total agriculture, did better: it increased 1 percent during the period from the early 1980s to the late 1980s.

The downward trend in agricultural production per capita was accompanied by a fall in the share of output going to exports. From 1948 to 1952, Peru exported 23 percent of its agricultural output; by 1976 the export share was down to 8 percent. The trade balance for the agricultural sector remained consistently positive through the 1970s but then turned into an import surplus for the 1980s.

Although agricultural production in the aggregate failed to keep up with population growth, a few important products stood out as exceptions. With favorable support prices, output of rice increased at an annual rate of 7.9 percent in the 1980s. Changes in production techniques helped raise output of chickens and eggs at a rate of 6.5 percent in this period. The Ministry of Agriculture interpreted these positive results as evidence of what could be accomplished more generally with better incentives and improvement of agricultural techniques. For many crops, extremely wide variations in output per hectare, even in similar conditions of land and water supply, suggest that if effective extension services were implemented average productivity could be raised to levels closer to those achieved by leading producers. Contrary to the experience of many other countries in the region, productivity for most crops other than rice showed little or no improvement from 1979 to 1989.

Obstacles to increasing agricultural production include the poor quality of much of the country's land and the high degree of dependence on erratic supplies of water, plus the negative effects of public policies toward agriculture. Frequent recourse to price controls on food and in some periods to subsidized imports of food have hurt agricultural incentives as a byproduct of efforts to hold down prices for urban consumers. In general, government policies have persistently favored urban consumers at the expense of rural producers.

Another important set of questions bearing on agricultural productivity concerns the effects of the Agrarian Reform Law of 1969. The reform itself came long after the beginning of the decline in output per capita and was at first accompanied by a brief upturn. But the downtrend set in again from 1972 on and continued through the 1980s. The major question about the effects of the reform on productivity concerns the fact that most of the large estates taken away from prior owners were turned into cooperatives, made up of the former permanent workers on the estates. One problem was that the workers lacked management experience and a second was that incentives for individual participants were often unclear. Shares in earnings of the cooperative as a whole were not closely related to the individual member's time and effort, with the result that many of them concentrated on small parcels allocated to production for their own families rather than production for the cooperative. The performances of the cooperatives turned out to be highly varied. Some, particularly those with relatively good land and markets were able to raise output and group earnings more successfully than the previous landowners. But many were not, and by the end of the 1970s many of the cooperatives were either bankrupt or close to becoming so. The tension between individual incentives and concern for the functions of the cooperative as a whole led to a general turn toward "decollectivization" at the end of the 1970s, breaking up the cooperatives into individual holdings. When the practice was made legal by the Belaúnde government in 1980, it spread rapidly. The decollectivization has given Peruvian agriculture a much stronger component of individual family farming than it has ever had before. The large haciendas are gone, and the new farms are closer to a viable family-supporting size than has been true of the minifundios of the Sierra. The consequences for agricultural productivity and growth were still unclear in 1991: incentives for individual effort were greater but the smaller production units may have lost some economies of scale. An econometric study of land productivity in north-coast agriculture, tracing output from prior cooperatives through individual results with the same land in the 1980s, brings out a wide variety of results rather than any great change in total. It shows that the individual holdings have on average done slightly better than the preceding cooperatives on the same land, chiefly by greater inputs of labor per hectare, but not enough better to make any convincing case of superiority. The authors of this study rightly emphasize that results in the 1980s cannot be explained adequately only in terms of farming practices because productivity was also adversely affected by the deterioration of the economic system as a whole.

In addition to the negative effects on agriculture of economy-wide disequilibrium in the 1980s, some areas were badly hurt in this period by increased violence and partial depopulation. The violence worsened from 1988 through 1990, driving people out of farms and whole villages and leaving productive land and equipment idle. In some of the worst-hit areas, production had fallen in half.


Peru - Fishing


Peru's rich fishery has been utilized since ancient times, but it was not until the post-World War II decades that an extensive export industry developed. Peru's fishing industry rapidly expanded in the 1950s to make the country the world's foremost producer and exporter of fish meal. Although a large variety of fish are caught offshore, the rapid growth was primarily in the catching of anchovies for processing into fish meal. The fish meal boom provided a major stimulus to the economy and accounted for more than a quarter of exports in the mid1960s .

In the 1960s, however, there were indications that the nation's offshore fishing area was being overfished. Experts estimated that the fish catch should be about 8 to 9 million tons a year if overfishing was to be avoided. In 1965 the government attempted to limit the annual fish catch to 7 million tons but without success, partly because investments in ships and processing facilities greatly exceeded that level. By the late 1960s, a finite resource was being depleted. In 1970 the anchovy catch peaked at over 12 million tons.

Peru's rich fishing grounds are largely the result of the cold offshore Humboldt Current (Peruvian Current) that causes a welling up of marine and plant life on which the fish feed. Periodically, El Niño (The Christ-child), a warm-water current from the north, pushes farther south than normal and disrupts the flow of the Humboldt Current, destroying the feed for fish. In such years, the fish catch drops dramatically. The intrusion of El Niño occurred in 1965, 1972, and 1982-83, for example. The 1972 catch, a quarter its peak size, contributed to a crisis in the fish meal industry and the disappearance of fish meal as a leading Peruvian export during most of the 1970s.

In 1973 the government nationalized fish processing and marketing. However, the fish industry became a large drain on the government budget as the national fish company paid off former owners for their nationalized assets, reduced excess capacity, and processed a meager catch of less than 4 million tons. Partly to reduce the drain on revenue, in 1976 the government sold the fishing fleet back to private enterprise. Emphasis was also shifted away from fish meal, mainly from anchovies, to edible fish and exports of canned and frozen fish products.

The fishing industry recovered in the late 1970s, but the return of El Niño in 1982-83 devastated the industry until the mid-1980s. By 1986 the total fish catch exceeded 5.5 million tons and by 1988, 5.9 million tons, with exports of fish meal valued at US$379 million. The 1989 catch totaled 10 million tons, an increase of 34 percent over 1988, and fish meal exports were worth US$410 million. In late 1991, Congress passed a decree that eliminated all restrictions and monopolies on the production and marketing of fish products and encouraged investment in the industry.


Peru - Manufacturing


The industrial sector has had its problems too, especially in the 1980s. Manufacturing production grew more rapidly than the economy as a whole up to that decade. It increased at a compound annual rate of 3.8 percent between 1965 and 1980. But it grew only 1.6 percent a year from 1980 to 1988, and then plunged 23 percent in the ghastly economic conditions of 1989.

Of dominant importance in the 1980s were food processing, textiles, chemicals, and basic metals; food processing alone accounted for nearly one-third of total manufacturing output. For the period 1980-88, when total manufacturing production increased by only about 5 percent, food processing rose by nearly 23 percent. Production of basic metals went the other way, falling by almost 22 percent. Output of metal products and machinery, closely associated with capital goods and investment, fell by 7 percent from 1980 to 1988, and then fell by one-fourth between 1988 and December 1989.

The weak picture for manufacturing in the 1980s did not result from any intrinsic obstacle on the side of productive capacity but from the overall weakness of the economy and of domestic markets. The sector's ability to increase production under better economic conditions was demonstrated by what happened between 1985 and 1987, in the successful first half of the García administration when aggregate demand was stimulated but inflation had not yet gotten out of control; manufacturing output shot up 34 percent between these two years.

The modern manufacturing sector has relied on relatively capital-intensive and import-intensive methods of production, failing to provide much help for employment. Manufacturing value increased from 20 to 22 percent of GDP between 1950 and 1990, but its share of total employment fell from 13 to 10 percent. Its dependence on imports of current inputs and capital equipment has probably resulted in large measure from the combination of an overvalued currency with high protection against competing imports. Overvaluation holds down the prices of imported equipment and supplies, making them artificially cheap relative to labor and other domestic inputs. Protection adds to the problem by allowing those firms that prefer the most modern possible equipment, even when it is more expensive than domestic alternatives, to pass on any extra costs to captive domestic consumers. In addition, protection saddled industrial firms themselves with high-cost inputs from other domestic firms, raising their costs to levels that have made it extremely difficult for even the most efficient to compete in export markets.

Growth of manufacturing, as of the whole economy, has been held back seriously by the failure so far to achieve any sustained growth of industrial exports. The sector acts as a drag on the possibilities of overall growth by using a great deal more of the country's scarce foreign exchange to import its supplies and equipment than it earns by its exports. This issue is key to future growth. Directing manufacturing production more toward exports would provide a new avenue for growth through sales to world markets and would also help relax the foreign-exchange constraints that so frequently hold back the whole economy.


Peru - Mining and Oil


The mining sector, including oil, accounted for only 9 percent of GDP in 1988 but nearly half of the country's export earnings. Its share of total exports increased from 45 percent in 1970 to 48 percent in 1988. Copper alone accounted for 24.4 percent of total export earnings in 1970 and 22.5 percent in 1988.

Mining developed as an export sector, first for precious metals and then chiefly for nonferrous metals needed by the industrialized countries rather than by non-industrialized Peru. Mining has always been an enclave, only weakly related to the domestic economy for its supplies or for its markets. But it has been a principal provider of the foreign exchange and tax revenue needed to keep the rest of the economy going. That key role made the dominance of foreign ownership, especially in copper and oil, a focus of bitter conflict for many years. The sector became the center of intense debate over dependency, exploitation, and national policy toward foreign investment.

Foreign investment was the main source of mining development up to the 1960s, starting from the turn of the century in copper and extending to a wide range of metals after the highly favorable Mining Code was enacted in 1950. The sector was divided between the largest mines, which produced roughly two-thirds of metal output and owned by foreign firms, and the small-to-medium size mines , which supplied the other one-third of output and were under Peruvian ownership. Following the Mining Code of 1950, foreign investment flowed into iron ore, lead, zinc, and other minerals, and metals exports grew from 21 percent of total exports in 1951 to over 40 percent a decade later.

When the military overthrew the government of Belaúnde in 1968, the immediate issue was a conflict with IPC, the foreign firm dominating the oil industry. The Velasco regime quickly nationalized IPC and then in the 1970s also nationalized the largest copper mining corporation, Cerro de Pasco. It established the Peruvian State Mining Enterprise (Empresa de Minería Peruana- -Mineroperú) as the main state firm for development of copper and the Peruvian State Mineral Marketing Company (Mineroperú Comercial--Minpeco) as the new state mining marketing agency.

Output of metal products was erratic in the early 1970s but then took a big jump with completion of a major new copper-mining project, Cuajone, in 1976. By 1980 value added in the sector, at constant prices, was 1.5 times as high as in 1970. But then in the 1980s, value added began to fall, along with practically everything else. By 1988 it was 14 percent below the 1980 level. The decrease could be explained to some degree by the general disorganization of the economy, but more specific problems were caused by increased guerrilla violence interrupting supplies and deliveries, and by prolonged strikes.

Extraction, refining, and domestic marketing of oil were under control of the Petroleum Enterprise of Peru (Petroleras de Perú--Petroperú) from 1968 to 1991. Foreign firms have been allowed to participate in exploration for new fields, although negotiations over their rights often has proved to be difficult. One foreign firm, Belco Petroleum Corporation, maintained offshore production until 1985, when its operations were nationalized after a dispute over taxes with the García government.

Output of oil products increased greatly in the course of the 1970s: its value at constant prices was 2.7 times as high in 1980 as in 1970. But then oil production joined the collective downtrend: it fell sharply between 1980 and 1985. Again, both the general disorganization of the economy and the increase in rural violence contributed to the decrease. Additionally controls on prices of oil products held them far below costs of production in the second half of the 1980s. That fact put Petroperú deeply into deficit and constrained its ability to finance both production and exploration. In 1990 petroleum contributed US$263 million to the value of the country's exports. The major changes introduced by the Fujimori government in 1990-91 included invitations for new investment by foreign oil companies, ending the monopoly position of Petroperú. Several foreign oil companies immediately entered negotiations to begin exploration activities, either independently or in collaboration with Petroperú.


Peru - Services


The formally legalized side of the service sector includes both government and private services. Government services, measured by payments for inputs in the absence of any recognized standard of output, have grown remarkably fast. As evaluated in current prices, government services increased from 4 percent of GDP in the decade of the 1950s to 9 percent in 1990.

Among the private service-sector activities, retail and wholesale trade has been the most important, accounting for 13.7 percent of GDP in 1988. Financial and business services were next most important at 8.5 percent of GDP, followed by transport and communications at 7.4 percent. Electricity and water constituted a small share of output in 1988, at 1.3 percent of GDP, but they increased at a very high rate from 1970 to 1988: their output in 1988 was 3.4 times as high as in 1970. Although these formal service-sector activities have, for the most part, shown significant growth even during the difficult 1980s, national accounts indicated that the largest of them--retail and wholesale trade--did not grow at all between 1980 and 1988. But that official measure was not readily credible, given the country's population growth and especially the rapid growth of the urban population. The official measure apparently reflected the fact that a growing share of trade was being carried out by unregistered individuals and firms.

Official statistics on production and employment are always subject to many reservations in Peru, as in all developing countries, but especially so for the service sector. Much of what is going on among these activities is outside the formal framework of the economy and very difficult to measure. In 1990- 91 many service activities were legally registered, reported sales and profits for tax purposes, and were in all respects within the formal accounting system of the economy. But many others were unregistered and might not even be known to exist as far as the government's statistics were concerned. That is true in any country for some activities, particularly those that operate against the law. It is also true on a massive scale in Peru for people who are just repairing shoes, making small items in their homes to sell in the streets, or in general trying to survive by activities that are perfectly normal and productive but not registered with the government. Peru has a massive informal sector, which includes more than half the total urban labor force. This sector accounts for a high proportion of personal services and retail sales activities, as well as considerable industrial production.

Exactly when and why these informal sector activities moved from a marginal to a large share of the economy are open questions. One strongly argued view, associated particularly with the work of Hernando de Soto, author of El otro sendero (The Other Path), is that regulatory activities of government proliferated from the 1960s onward, imposing intolerable costs on private business activities. A slightly different but consistent view is that the rapid growth of the informal sector coincided with increased business taxation, beginning at the end of the 1960s. The two interpretations fit each other, but the former lends itself more to a general argument against government regulation of business, without paying much attention to the fact that the growth of the informal sector means a shrinking tax base for the society.

Both of these analyses surely capture much of the causation behind the growth of the informal sector in Peru, but they may deflect attention from two other explanations that could be more important. One of them concerns the generalized deterioration of the economy and the consequent weak growth of job opportunities in formal-sector employment. With the rapid growth of the labor force, and a high rate of migration to the cities, the number of people looking for work far outpaced the number of formal job openings. The answer for those without regular employment in the formal sector has been to create self-employment activities of their own or to work for relatives in small-scale operations, often on a basis of family sharing rather than regular wage employment. These people do everything from selling coat hangers on sidewalks in the center of the city to putting together computers from discarded spare parts. In this view, the problem is not so much government regulation or excess taxation as it is one of macroeconomic failure of the economy as a whole. The informal sector may be in part a way to avoid regulation, but more fundamentally it is a necessary means of survival, a constructive answer on the individual level to lack of success at the level of the macroeconomy.

Still another interpretation that must be considered centers on the background of the migrants to the cities. They have been native Americans and mestizos from rural communities in which ways of earning a living are bound within traditional family and community relationships. Production is carried out on a self-employed or very small-scale basis with a minimum of the kinds of accounting, financial, and legal complications of modern society. The new migrants to the cities look for work and guidance from former migrants and especially relatives from the same communities who are carrying on much the same kinds of activities as they knew at home. They recreate in Lima the kinds of informal activities they have always known. In this view, the informal sector is largely a cultural phenomenon, by no means explicable in purely economic terms.

Succeeding governments have gone back and forth in their treatment of the informal sector, at times trying to crack down on unregistered vendors and their sources of supply, and at other times trying to provide them with information and technical help. The formal business sector might be expected to press for regulation of these activities because the legally registered firms must pay the higher costs of following regulations and paying taxes: competition is not even. But then the formal sector is itself divided. Because some of these firms cut their own costs by subcontracting activities to the informal sector, to some degree they share in the same profit from being outside the law. Everyone recognizes that the informal sector is the source of livelihood for a great many people without alternative opportunities and that helping to make them more productive could yield important gains for them and for Peru. The other side of the coin is that those in this sector pay no attention to the legal system, to health and safety regulations, or to the society's need for a tax base to support necessary public functions.


Peru - Banking


In 1987 the García government attempted to nationalize Peru's banks, financial institutions, and insurance companies. Under the legislation, which Congress approved despite a judicial ruling against the government's proposals, the government was to hold 70 percent of shares of nationalized banks, with the remaining 30 percent offered for sale to the public. The legislation excluded foreign banks operating in Peru from the nationalization program but prohibited them from opening any new branches in Peru. This set of proposals stimulated widespread public opposition and provoked a breakdown of cooperation between business leaders and the government. Private investment fell abruptly. García attempted to pursue the nationalization despite all the opposition, but adverse judicial rulings slowed implementation and finally killed the proposals.

In early 1991, Peru's financial system included four development banks, twenty-two commercial banks, eight credit firms (financieras de crédito), fifteen savings-and-loan mutuals (mutuales), twelve municipal savings-and-loans institutions, and the Savings Bank of Lima (Caja de Ahorros de Lima). In May 1991, the Fujimori government introduced a new package of economic measures designed to liberalize the banking system. The government suspended the powers of the Central Reserve Bank (Banco Central de Reservas, or BCR--hereafter Central Bank) to set interest rates and allowed them to float according to market forces. It also stipulated that in the future foreign banks would be able to operate in Peru under the same conditions as Peruvian banks. In addition, it amended the Agrarian Reform Law of 1969 by allowing farmers to put up their land as collateral for bank loans. When it went into effect in June 1991, the new banking law shook up the state banking sector, which employed 20,000 people and included six state-owned banks. The new law eliminated specialized banks, credit firms, and mortgage-lending mutuals, forcing them to reorganize as commercial banks.


Peru - Tourism


Lima, with its Spanish colonial architecture, and Cusco, with its impressive stonework of pre-Inca and Inca civilizations, notably at Machupicchu, are the centers of Peru's ailing tourism industry. Lake Titicaca also constitutes a major tourist attraction. However, as a result of terrorism, insurgency, common crime, the 1990-91 cholera epidemic, and the April 1992 coup, tourism has declined drastically since 1988, when Peru received an estimated 320,000 foreign visitors and US$300 million in tourism earnings. One American tourist was murdered in Cusco in early 1990, and several others died in the late 1980s because of sabotage of a train line between Cusco and Machupicchu. Under sharply increased taxes on tourism imposed in 1989 in response to declining numbers of tourists, foreigners have had to pay far more than Peruvians for internal flights and visits to museums and archaeological sites. In 1989 six flights a day shuttled tourists between Cusco and Lima, but by late 1990 there were only two. Tourist arrivals in Peru continued to decline in 1990 and 1991.

According to the National Tourism Board (Cámara Nacional de Turismo--Canatur), tourism in the first half of 1992 was down 30 percent from the first semester of 1991, which, in turn, fell 70 percent from 1988, tourism's record year. A major blow to Lima's hotel business was the SL's car bomb attack in the exclusive Miraflores district on July 16, 1992, in which six major hotels suffered over US$1 million in damages. The number of tourists visiting Cusco and Machupicchu had dropped 76 percent since 1988.

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Peru - Employment


The Peruvian labor force increased from 3.1 million workers in 1960 to 5.6 million by 1980, and to 7.6 million by 1990. As it did so, the share of the labor force in agriculture steadily decreased, but the shares in manufacturing and mining failed to rise. On balance, the decreases in the agricultural share had to be offset by increases in the share in service activities, some of them offering productive employment at abovepoverty income levels but many of them not.

Peru's long process of transition away from a rural society was far from complete at the beginning of the post-World War II period. Fifty-nine percent of the labor force was still working in agriculture in 1950. That share fell to barely over half by 1960 and to 34 percent by 1990. The more surprising trend is that the share of the labor force in manufacturing also fell, from 13 percent in 1950 to 10 percent by 1990. Stable shares in both construction and mining meant that the shift out of agriculture went mainly toward services, pulling their share of employment up from 23 percent in 1950 to 50 percent by 1990.

The persistent decrease in the share of the labor force in agriculture could in theory have helped to alleviate rural poverty by leaving higher average land holdings to those remaining in agriculture. But the absolute number of people trying to make a living from inadequate land holdings actually increased. The labor force in agriculture rose 52 percent between 1960 and 1990. In addition, emigration from agriculture exerted increasing pressure on labor markets in the cities, and the increase in rural workers kept earnings low in that sector.

A growing labor force need not drive wages down and in most instances does not, provided that investment and technical change keep opening up new opportunities for productive employment fast enough to absorb the larger number of workers. Peru managed to accomplish such growth in the first post-World War II decades, but from the early 1970s the trend went downward. As more and more workers tried to survive in the service sector by selfemployment or work with families instead of formally registered firms, they created a rapidly growing informal sector. Workers in the informal sector are mostly employed, and they certainly add to national income, but their earnings are often below the poverty line.

Overt unemployment that can actually be counted has been only a small part of the problem. The overt unemployment level in Lima was an estimated 7 percent in 1980, rising to 8 percent by 1990. But estimates of underemployment in part-time or very low-income activities indicate that 26 percent of Lima's labor force was in this category in 1980, and fully 86 percent in 1990. Such measures are invariably somewhat arbitrary, depending on how underemployment is defined and measured. However, the fact that the share of Lima's labor force fitting the definition more than tripled between 1980 and 1990 is readily understandable in the light of the deterioration of the economy in the 1980s.


Peru - Wages


Real wages in Peru rose when the economy was advancing in the 1950s and 1960s but then began to go down persistently. From 1956 to 1972, average wages in manufacturing increased at an annual rate of 4.1 percent. But then from 1972 to 1980, they went back down at the rate of 3.6 percent a year, and from 1980 to 1989 they went further down at the rate of 5.2 percent a year. Although comparisons of real wage levels over long periods are inherently uncertain, given many changes in the structures of wages and prices, it seems evident that real wages in Peruvian manufacturing were much lower in 1989 than they had been a third of a century earlier.

Even in comparison with the sharp fall in manufacturing real wages during the 1980s, the concurrent plunge in real minimum wages for urban workers was appalling. While the average for manufacturing fell 58 percent from 1980 to 1989, the real minimum wage fell 77 percent; the purchasing power of the minimum wage in 1989 was less than one-fourth its level in 1980.

The minimum wage applies to legally employed workers in the formal sector. The much larger number of workers in the informal sector, not covered by the minimum wage, also lost purchasing power in the course of the 1980s but apparently not as drastically. An index of real earnings in the informal sector shows a decrease of 28 percent between December 1980 and December 1989. That index also shows extreme volatility. Real earnings rose steeply between December 1980 and December 1987, almost doubling in this period, and then plunged to a level far below the starting point.


Peru - Organized Labor


In labor markets as weak as those of Peru from the early 1970s onward, organized labor has not normally had any great bargaining power. It could affect the political balance, but it has not been able to do much to keep real earnings from falling when the economy declined. Peruvian labor has never been more than moderately organized in any case: unionization did not take off significantly until the political climate changed with the reformist military government of 1968. Labor has played a more active political role since that time, but has not so far been able to prevent deterioration of real wages.

Organized labor in Peru got off to a slow start in the interwar period (1919-40), compared with active unionism in Argentina, Chile, and Venezuela. Still, the textile workers, in the one sizeable industry of the time, managed to defy the government and win a famous strike in 1919. They gave the credit to a student activist who stepped in to lead them and negotiated an impressive victory. The activist, Víctor Raúl Haya de la Torre, went on at the beginning of the 1930s to found the American Popular Revolutionary Alliance (Alianza Popular Revolucionaria Americana- -APRA), the country's first mass-based political party. Haya de la Torre simultaneously promoted organization of labor through the Confederation of Peruvian Workers (Confederación de Trabajadores del Perú--CTP) and consolidated a close partnership between APRA and the CTP. The CTP was the dominant voice of labor until Haya de la Torre allied himself with the conservative side of the political spectrum during the 1960s. That move to the right then stimulated the growth of a rival Communist-led labor federation, the General Confederation of Peruvian Workers (Confederación General de Trabajadores del Perú--CGTP).

Neither APRA nor the labor movement made much headway under the conservative governments in office up to the 1960s. But after the reformist military government took power in 1968, unionization spread rapidly. More new unions were given legal recognition from 1968 to 1978 than in all prior Peruvian history: there were 2,152 recognized unions in 1968 and 4,500 by 1978. The new unions, less tied to APRA, began to strike out more on their own to undertake joint negotiations and demonstrations with community groups of all kinds. The military government began to regard unions less as allies and more as sources of opposition, and in fact labor became a center of resistance to military authority all through the 1970s.

Although the Velasco government was committed in many respects to support of popular organizations, its relationships with organized labor turned into conflicts in two fundamental ways. One was purely economic; the government was initially determined to prove its ability to avoid inflation, which it identified as evidence of the inherent weakness of civilian governments. Increase in wages was seen as a threat to control of inflation, and wages in general were considered a matter to be decided by government rather than unions.

The second and more general source of conflict was that the Velasco government had a strongly corporatist conception of social order, in which labor unions had their place but had no business trying to change it. The government was deeply opposed to theories of class conflict. Labor and capital alike were expected to recognize that their interests had to be reconciled for the good of the society as a whole. The military welcomed and sponsored public organizations but distrusted any signs of excessive autonomy.

Once in open conflict with the two main labor confederations, the government tried to undercut them by creating a new one, the Federation of Workers of the Peruvian Revolution (Central de Trabajadores de la Revolución Peruana--CTRP). The new confederation received government help in getting favorable wage settlements and added to the scope of labor organization but had little effect in actually weakening the more independent unions.

In the economic contraction following 1975, labor played a more active role of social protest than ever before. The first general strike in the country's history, in July 1977, seemed to herald a new epoch in labor relations in Peru. Labor's support for left-oriented parties, no longer so predominantly for APRA, became evident in the elections of 1980. In terms of wage trends, the more active role of organized labor has not seemed to make much difference. Organized labor certainly did not stop the devastating fall of real wages in the 1980s. Still, average wages for workers under collective bargaining contracts have been much higher than those for workers without them. As of December 1986, the average wage for those with contracts was 2.2 times that of workers without them. That ratio fell to 1.7 by December 1989, as everyone's real wages plunged.


Peru - Poverty


Whether poverty is measured in terms of family income or in terms of social indicators, such as child mortality, it has been greater in Peru than would be expected on the basis of the country's average income per capita. Historically, this situation has been an expression of the country's exceptionally high degree of inequality. More recently, especially in the course of the 1980s, it increased even more than in the other major Latin American countries, chiefly because of the drastic deterioration of the economy's overall performance.

Measures of poverty based on family income are, of course, dependent on the particular income level chosen as a dividing line between the poor and the non-poor. Both the Economic Commission for Latin America and the Caribbean (ECLAC) and the World Bank draw two lines--one for a tightly restricted income level to define extreme poverty, or destitution, and a second cutoff for poverty in a less extreme sense. Destitution refers to income so low that it could not provide adequate nutrition even if it were spent entirely on food. Poverty in the less extreme sense takes as given the proportion of income spent on food in each society and compares that proportion to the level needed for adequate nutrition.

A comprehensive analysis of poverty in Latin America for 1970 concluded that fully 50 percent of Peruvian families were below the poverty line and 25 percent were below the destitution level. These proportions were both higher than Latin America's corresponding averages--40 percent in poverty and 19 percent in destitution. In Peru, as in the rest of Latin America, the incidence of poverty and destitution was much higher for rural than for urban families. Fully 68 percent of rural families were below the poverty line, compared with 28 percent of urban families.

A more recent ECLAC study provides new estimates of the incidence of poverty for 1980 and 1986. For Latin America, the share of families in poverty fell from 40 percent in 1970 to 35 percent in 1980 but then rose to 37 percent in the more difficult conditions of 1986. For Peru, the incidence of poverty also fell from 50 percent in 1970 to 46 percent in 1980, but then it increased to 52 percent by 1986, rising faster than the rest of the region.

As in 1970, the incidence of poverty and destitution in 1986 remained higher for rural than for urban families, but the differences had lessened. In 1970 the incidence of poverty for rural families was 2.4 times that for urban families; in 1986 the ratio was only 1.4 times. The proportion of rural families in poverty actually fell, from 68 percent to 64 percent, while that of urban families rose greatly, from 28 percent to 45 percent.

Cuánto S.A. has developed an ongoing monthly indicator of extreme poverty in Peru, combining measures of earnings by workers paid the minimum wage with earnings in the informal urban sector and in agriculture. Taking January 1985 as the starting point, this index shows a substantial fall in extreme poverty up to December 1987, in the first years of the García government's expansion. But then it shows a dramatic increase as the economy went rapidly downhill. At the end of the García administration, in June 1990, the index was 91 percent higher than in December 1987 and 32 percent higher than its starting point in January 1985.


Peru - Income Distribution


The distribution of income in Peru has been exceptionally unequal for a long time, but by some measures the degree of inequality apparently decreased between 1970 and 1985. The main causes of inequality have changed as well, in some ways for the better and in some for the worse.

In the pre-World War II years, the dominant causes of inequality were a very high concentration of ownership of land and access to capital and to education, along with a sociopolitical structure that condemned the indigenous rural population to bare subsistence with little chance of mobility. In the post-World War II period, especially since the 1960s, access to education gradually has spread to rural areas, and increased migration to the cities has opened up new opportunities for people previously blocked in poverty-stricken rural occupations. The Agrarian Reform Law of 1969 wiped out large private land holdings and led in the 1980s to a vastly less unequal distribution of individual ownership. The rise of production and export of coca probably also played a role in raising rural incomes in the 1980s.

More positively, if only for a brief period from 1985 to 1987, the agrarian policies of the García government helped stimulate agricultural markets and production, and controls on prices in the industrial sector served to raise greatly the ratio of agricultural to industrial prices. As has been noted, the proportion of the rural population below the poverty line fell from 68 percent in 1970 to 64 percent by 1986, while that for urban families was rising from 28 percent to 45 percent. The positive change for rural families was small, and the negative change for urban families was large, but because urban poverty was initially less the degree of inequality between the rural and urban sectors decreased.

Other changes in the post-World War II years worked in the opposite direction, toward greater inequality. The turn to industrial protection raised profits of industrialists relative to other forms of income and also raised the prices of their products relative to those of the agricultural sector. Wages for organized workers in manufacturing rose relative to wages of lower-income rural and unorganized labor, as well. The pressure of a rapidly growing labor force against the society's limited openings for productive employment acted in general to keep downward pressure on labor income relative to property income. That imbalance worsened in the 1980s when the chaotic conditions of the economy as a whole made employment conditions more difficult.

During the period of exceptional economic growth from 1961 to 1972, the incomes of the poorest 60 percent of Peruvian families increased at a rate of 2.3 percent a year, just matching the rate of growth of national income. As growth weakened from the mid1970s , both average real wages and minimum real wages began a prolonged decline, and total wages fell relative to incomes of property owners. But earnings of the lowest income groups in agriculture went up, slightly reducing the percentage of rural families falling below the poverty line. A World Bank study concludes that these changes reduced the degree of inequality between 1972 and 1985: the share of the poorest 60 percent increased from 18 to 27 percent of total income.

An alternative measure of inequality, the Gini index, shows a similar improvement. The higher the coefficient, the higher the degree of inequality. In the early 1960s and again in the early 1970s, Peru had either the highest or the second highest Gini coefficient for all the Latin American countries measured, at 0.61 for 1961 and 0.59 for 1972. By 1985 it had come down to 0.47, far below Brazil and only slightly higher than Colombia. These countries all have high inequality by world standards, but in 1985 Peru no longer stood out as the worst.

The latest estimate available, for 1988, suggests that inequality had increased slightly compared with 1985, with the Gini coefficient rising from 0.47 to 0.50. Although not a drastic change in itself, its connotations are worsened by the simultaneous rise in poverty. The latter may well be considered to be the more important matter: it would not mean much to reduce inequality if that just meant more equal sharing of greater poverty. The one clearly positive combination of indicators is that for the period 1980-85 the incidence of poverty fell, if only slightly, for the rural households who have always constituted the majority of Peru's poor.


Peru - The Velasco Government


The economic strategy of the Velasco government was shaped by a conception frequently advocated in Latin America but rarely put into practice. The idea was to find a "third way" between capitalism and socialism, with a corporatist society much more inclusionary than that possible under capitalism but without rejecting private ownership or adopting any of the compulsory methods identified with communism. Under this strategy, land reform was designed to override existing property interests in order to establish cooperative ownership, rejecting both individual private farming and state farms. Promoting worker participation in ownership and management was intended to reshape labor relations. Foreign influences were reduced through tight restrictions on foreign investment and nationalization of some of the largest foreign firms. On a more fundamental plane, the Velasco government saw its mission as one of eliminating class conflict and reconciling differences among interest groups within its own vision of a cooperative society.

Land Reform

The most striking and thorough reform imposed by the Velasco government was to eliminate all large private landholdings, converting most of them into cooperatives owned by prior workers on the estates. The reform was intended to destroy the basis of power of Peru's traditional elite and to foster a more cooperative society as an alternative to capitalism. Such socialpolitical purposes apparently dominated questions of agricultural production or any planned changes in patterns of land use. It was as if the questions of ownership were what mattered, not the consequences for output or rural incomes. In fact, the government soon created a system of price controls and monopoly food buying by state firms designed to hold down prices to urban consumers, no matter what the cost to rural producers.

As mentioned earlier, the cooperatives had very mixed success; and the majority were converted into individual private holdings during the 1980s. The conversions were authorized in 1980 by changes in the basic land reform legislation and were put into effect after majority votes of the cooperative members in each case. The preferences of the people involved at that point clearly went contrary to the intent of the original reform. But the whole set of changes was not a reversion to the pre-reform agrarian structure. In fact, the conversions left Peru with a far less unequal pattern of landownership than it had prior to the reform and with a much greater role for family farming than ever before in its history.

Labor and Capital in the Industrial Sector

In line with its basic conception of social order, the military government also created a complex system of "industrial communities." Under this system, firms in the modern sector were required to distribute part of their profits to workers in the form of dividends constituting ownership shares. The intent was to convert workers into property owners and property ownership into a form of sharing for the sake of class reconciliation. But in practice, the system never functioned well. The firms did all they could to avoid reporting profits in order to postpone sharing ownership, sometimes by setting up companies outside the system to which they channeled profits, sometimes by adjusting the books, and in general by keeping one step ahead of intended regulations. A small fraction of the industrial workers gained shares in firms, but as a rule workers were not so much interested in long-term claims of ownership as they were in immediate working conditions and earnings. For organized labor, the whole approach seemed an attempt to subvert any role for union action and to make organization irrelevant. The system was not popular with either side. It was quickly abandoned when the more conservative wing of the military took power away from General Velasco in 1975.

Attempted reform of labor relations in the mid-1970s also included severe restrictions on rights to discharge workers once they passed a brief trial period of employment. A review process set up to examine disputes was implemented in a way that made discharges practically impossible. Businesspeople circumvented the restrictions to some degree by hiring workers on a temporary basis up to the point at which they would have to be kept and then letting them go before the restrictions applied. Businesspeople remained unremittingly hostile to this type of regulation, primarily on the grounds that it took away their main means of exercising discipline over their workers. This form of regulation was also eliminated shortly after Velasco lost power.

Protection and Promotion of Industry

Along with the intention of resolving internal class conflict, the Velasco government determined to lessen Peru's dependency on the outside world. The two most important components of the strategy were a drive to promote rapid industrialization and an attack on the role of foreign firms. In contrast to the industrialization strategies of most other Latin American countries, the intention of the Velasco regime was to industrialize without welcoming foreign investment.

The preceding Belaúnde administration had started Peru on the path of protection to promote industry, and in this respect the Velasco government reinforced rather than reversed the existing strategy. Beyond the usual recourse to high tariffs, Velasco's government adopted the Industrial Community Law of 1970 that gave any industrialist on the register of manufacturers the right to demand prohibition of any imports competing with his products. No questions of exceptionally high costs of production, poor product quality, or monopolistic positions fostered by excluding import competition were allowed to get in the way. Before the succeeding government of General Francisco Morales Bermúdez Cerrutti (1975- 80) began to clean up the battery of protective exclusions in 1978, the average tariff rate reached 66 percent, accompanied by quantitative restrictions on 2,890 specific tariff positions.

In addition to the protective measures, the Velasco government promoted industrial investment by granting major tax exemptions, as well as tariff exemptions on imports used by manufacturers in production. The fiscal benefits given industrialists through these measures equaled 92 percent of total internal financing of industrial investment in the years 1971 through 1975.

Investment rose strongly in response to these measures, as well as to the concurrent rise in aggregate demand. But the tax exemptions also contributed to a rising public-sector deficit and thereby to the beginning of serious inflationary pressure. In addition, the exemptions from tariffs given to industrialists on their own imports of equipment and supplies led to a strong rise in the ratio of imports to production for the industrial sector.

Nationalizations and State Firms

The industrialization drive was meant to be primarily a Peruvian process not totally excluding foreign investors but definitely not welcoming them warmly. In that spirit, the Velasco regime immediately nationalized IPC in October 1968 and, not long after that, the largest copper mining company, while taking over other foreign firms more peacefully through buy-outs. The government put into place new restrictions on foreign investment in Peru and led the way to a regional agreement, the Andean Pact, that featured some of the most extensive controls on foreign investment yet attempted in the developing world.

The decision to nationalize the foreign oil firm was immensely popular in Peru. It was seen as a legitimate response to many years of close collaboration between the company, which performed political favors, and a series of possibly selfinterested Peruvian presidents, who, in exchange, preserved the company's exclusive drilling rights. Nationalization was perhaps less a matter of an economic program than a reaction to a public grievance, a reaction bound to increase public support for the new government.

Subsequent nationalizations and purchases of foreign firms were more explicitly manifestations of the goals of building up state ownership and reducing foreign influence in Peru. The leaders of the military government subscribed firmly to the ideas of dependency analysis, placing much of the blame for problems of development on external influences through trade and foreign investment. Foreign ownership of natural resources in particular was seen as a way of taking away the country's basic wealth on terms that allowed most of the gains to go abroad. Ownership of the resources was expected to bring in revenue to the government, and to the country, that would otherwise have been lost.

In contrast to its abrupt nationalization of the IPC and then of the largest copper mining company, the government turned mainly to purchases through negotiation to acquire the property of the International Telephone and Telegraph Company (ITT) and foreign banks. Partly in response to United States reactions to the earlier nationalizations, and perhaps also partly in response to the realization that foreign investment might play a positive role in the industrialization drive, the government began to take a milder position toward foreign firms. But at the same time, it pursued a policy of creating new state-owned firms, in a sense competing for position against domestic private ownership, as well as against foreign ownership.

State ownership of firms was, of course, consistent with the nationalizations but reflected a different kind of policy objective. Whereas the nationalizations were intended to gain greater Peruvian control over the country's resources and to reduce the scope of foreign influence, the proliferation of state-owned firms was meant to increase direct control by the government over the economy. State firms were seen as a means to implement government economic policies more directly than possible when working through private firms, whether domestic or foreign-owned. The goal was not to eliminate the private sector-- it was encouraged at the same time by tax favors and protection-- but to create a strong public sector to lead the way toward the kind of economy favored by the state.

The new state firms created in this period established a significant share of public ownership in the modern sector of the economy. By 1975 they accounted for over half of mining output and a fifth of industrial output. One set of estimates indicates that enterprises under state ownership came to account for a higher share of value added than domestic private capital: 26 percent of GDP for the state firms, compared with 22 percent for domestic private firms. The share produced by foreign-owned firms dropped to 8 percent from 21 percent prior to the Velasco government's reforms.

Contrary to the expectation that the earnings of the state firms would provide an important source of public financing for development, these companies became almost immediately a collective drain. In some measure, the drain was a result of decisions by the government to hold down their prices in order to lessen inflation or to subsidize consumers. In addition, deficits of the state-owned firms were aggravated by the spending tendencies of the military officers placed in charge of company management and by inadequate attention to costs of production. The collective deficits of the state enterprises plus the subsidies paid directly to them by the government reached 3 percent of GDP by 1975. State enterprises were not able to finance more than about one-fourth of their investment spending. The government attempted to answer the investment requirements of the state firms by allowing them to borrow abroad for imported equipment and supplies. They did so on a large scale. The external debt rose swiftly, for this and for other reasons discussed below.

Nationalizations and the creation of new state firms stopped abruptly after Velasco lost power. In 1980 the Belaúnde government announced a program to privatize most of the state firms, but it proved difficult to find private buyers, and few of the firms were actually sold. In the opposite direction, the subsequent García government, in addition to nationalizing in 1985 the offshore oil production of the Belco Corporation, a United States company, tried in 1987 to extend state ownership over banks remaining in private hands. The attempted banking nationalization created a storm of protest and was eventually ruled to be illegal. The failures under both Belaúnde and García to change the balance left the state-enterprise sector basically intact until Fujimori implemented major changes.

Macroeconomic Imbalance: Domestic and External

Whatever the promises and the costs of the many kinds of reform attempted by the Velasco government, the ship sank because of inadequate attention to balances between spending and productive capacity, and between export incentives and import demand. The Velasco government inherited recessionary conditions in 1968, with a positive external balance and productive capacity readily available for expansion. It maintained effective restraint on spending and deficits for several years but then let things get out of control. The central government's deficit was no more than 1 percent of gross national product (GNP) in 1970, but its own deficit plus that of the greatly expanded group of state firms reached 10 percent of GNP by 1975. Correspondingly, the external current-account balance was positive in the period 1968-70 but showed a deficit equal to 10 percent of GNP by 1975.

The external deficit was driven up primarily by high rates of growth of domestic demand and production through 1974. But in addition, the government's policy of holding to a fixed nominal exchange rate, in an increasingly inflationary context, allowed the real exchange rate to fall steadily from 1969 to 1975. The government refused to consider devaluation for fear it would worsen inflation and managed to avoid it by borrowing abroad to finance the continuing deficit. By 1975 external creditors had lost confidence in Peru's ability to repay its debts and began to put on the brakes. Whether because of such external pressure or because of growing internal opposition to the increasingly arbitrary decisions of the government, the Peruvian military decided to replace Velasco in 1975. The experiment ended on a note of defeat, not so much of its objectives as of its methods.


Peru - The Second Belaúnde Government


The return to democracy allowed Peruvians to choose among strongly left, strongly conservative, or middle-of-the-road parties. They chose Belaúnde and his party as the middle road, but it led nowhere. The Belaúnde government tried to return the economy to a more open system by reducing barriers to imports, implementing financial reforms intended to foster private markets, and reversing the statist orientation of the Velasco system. But the new approach never had a chance to get very far because of a series of macroeconomic problems. On one side, the government was rightly concerned about continuing inflation but made the mistake of focusing the explanation on monetary growth arising from the export surplus it inherited at the start. That position made it seem undesirable to continue trying to promote exports and desirable to raise domestic spending and imports. On the other side, President Belaúnde's personal and political objectives included using public investment actively to develop the interior of the country and to answer evident needs for improved infrastructure. Seeing the export surplus as the key macroeconomic source of imbalance, the government decided to eliminate it by removing import restrictions, slowing nominal devaluation to allow the real exchange rate to appreciate, and increasing government investment spending.

The real exchange rate appreciated through 1981 and 1982, public sector investment rose 54 percent in real terms from 1979 to 1982, and public sector consumption rose 25 percent during the same three-year period. The combination effectively turned the current-account surplus into a large deficit, as increased spending plus import liberalization practically doubled imports of goods and services between 1979 and 1981. The appreciation also turned manufacturing exports back downward, and a plunge in external prices of primary exports brought them down too. And then the mistake of focusing on the earlier export surplus as the main cause of inflation became clear: the increases in spending led to a leap of inflation despite the return to an external deficit. The rate of inflation went from 59 percent in 1980 to 111 percent by 1983.

Nothing improved when the government then tried to go into reverse with contractionary macroeconomic policies and renewed depreciation. Output plunged, but inflation once more went up instead of down, to 163 percent by 1985. By this time, pessimism about the government's capacity to solve anything, inflationary expectations turning into understandable convictions, and the price-increasing effect of devaluation all combined to give Peru a seemingly unstoppable inflation despite the elimination of anything that might be considered excess demand. The government apparently lost its sense of direction, retreated from its attempt to reopen the economy by returning to higher tariff levels, and otherwise did little except wait for its own end in 1985.


Peru - The García Government


With the market-oriented choice of economic strategy discredited by results under Belaúnde, Peruvians voted for the dynamic populist-reformist promise of García and responded enthusiastically to his sweeping changes. García's program worked wonders for two years, but then everything began to go wrong.

The main elements of the economic strategy proposed by the García government were full of promise. They recognized the prior neglect of the agricultural sector and called for redirecting public programs toward promotion of agricultural growth and reduction of rural poverty. Correspondingly, economic activity was to be decentralized to break down its high concentration in Lima, and within the cities resources were to be redirected away from the capital-intensive and import-intensive modern sector to the labor-intensive informal sector. A strategy of concertación (national understanding) with private business leaders on economic issues was to be used systematically to avoid disruptive conflict. Problems of external balance were to be answered both by restructuring production to lessen dependence on imports and by reorienting toward higher exports over the long-term.

These goals for structural change could have improved the efficiency of resource allocation while doing a great deal to lessen poverty. But the goals clearly required both time and the ability to restore expansion without worsening inflation and external deficits. The government initially emphasized such macroeconomic objectives as necessary conditions for the structural changes. The first step was to stop the built-in inflationary process, but to do it without adopting orthodox measures of monetary and fiscal restraint.

To stop inflation, the government opted for heterodox policies of control within an expansionary program. Prices and wages in the modern sector were to be fixed, after an initial one-shot increase in wage rates. The increase in wages was intended to raise living standards of workers and stimulate production by raising sales to consumers. To offset the effects of higher wages on costs of production, financial costs of the business sector were cut by intervention in order to reduce and control interest rates. After making one adjustment of the exchange rate to minimize negative effects on exports, the government stopped the process of continuing devaluation in order to help hold down inflation. Imports were rightly expected to go up as the economy revived; to help finance them, García made his controversial decision to stop paying external debt service beyond 10 percent of the value of exports. Unorthodox as they were, all the pieces seemed to fit. At least, they went together well at the start under conditions of widespread idle capacity, with an initially strong balance of payments position.

The macroeconomic measures worked wonders for production. GDP shot up 9.5 percent in 1986 and a further 7.7 percent in 1987. Manufacturing output and construction both increased by more than one-fourth in these two years. An even greater surprise was that agricultural production per capita went up, running counter to its long downward trend. And the rate of inflation came down from 163 percent in 1985 to 78 percent in 1986, although it edged back up to 86 percent in 1987. In response to stronger market conditions and perhaps also to growing confidence that Peru's economic problems were at last being attacked successfully, private fixed investment went up by 24 percent in 1986, and capital flight went down.

The government avoided any spending spree of its own: central government spending was actually reduced in real terms each year. But because the government also reduced indirect taxes in order to encourage higher private consumption and to reduce costs for private business, its originally small deficit grew each year. The economic deficit of the nonfinancial public sector as a whole (excluding interest payments) went up from 2.4 percent of GDP in 1985 to 6.5 percent by 1987.

Although the government reduced its total spending, it managed to support a new public works program to provide temporary employment and to direct more resources to rural producers as intended in its program for structural change. Three lines of policy helped especially to raise rural incomes. The first was to use generous guaranteed prices for key food products. The second was to provide greatly increased agricultural credit, financed essentially by credit from the Central Bank. The third was to exempt most of the non-guaranteed agricultural prices from controls, allowing their prices to rise sharply relative to those of industrial products from the modern sector. From July 1985 to December 1986, prices of goods and services not under control increased more than three times as much as those under control. Wholesale prices in manufacturing increased 26 percent, but those for agricultural products increased 142 percent.

Besides higher employment and living standards, the first two years of economic revival seemed to offer a break in the cycle of rising rural violence. The flow of displaced peasants from the Sierra eased, and a good many peasants began to return to the countryside. That reverse might be explained by García's initial efforts to reduce reliance on military force to combat the guerrillas and thereby to lessen the degree of two-way violence driving people out of their villages. But the trend may also have been a response to the reality of better economic conditions and earning possibilities in the agricultural sector.

The first two years of the García government gave new hope to the people of Peru, with rising employment, production, and wages suggesting a clear turn for the better after so many years of increasing difficulties. It was hence doubly tragic to see the whole process unravel so quickly, once things started going wrong again. The first sign of trouble came, as it often had, from the balance of payments. The economic boom naturally raised imports swiftly, by 76 percent between 1985 and 1987. But the real exchange rate was allowed to fall by 10 percent in 1986 and by a further 9 percent in 1987. The boom pulled potential export supply into the domestic market, and the fall in the real exchange rate reduced incentives to earn foreign exchange. Exports fell slightly in 1985 and remained below that level through 1987. The external current account went from a surplus of US$127 million in 1985 to deficits of nearly US$1.1 billion in 1986 and nearly US$1.5 billion in 1987.

The García government reacted to the growing external deficit in exactly the same way as had the governments of Velasco and of Belaúnde--by postponing corrective action while the problem continued to worsen. As ever, a major fear was that devaluation would worsen inflation. Inflationary pressures were, in fact, beginning to worsen behind the façade of control. To some degree, they were growing in response to the high rate of growth of demand and output, reducing margins of previously underutilized productive capacity. But the more explosive pressures were being built up by relying on price controls that required a dramatic expansion of credit to keep the system in place. Prices of public sector services--gasoline above all, oil products in general, electricity, telephones, and postal services--were frozen at levels that soon became almost ridiculous in real terms. The restrictions on prices charged by state firms drove them ever deeper into deficits that had to be financed by borrowing. The borrowing came from wherever it could, but principally from the Central Bank. At the same time, Central Bank credit rose steadily to keep financing agricultural expansion. Still another direction of Central Bank credit creation was the financing used to handle the government's new structure of multiple exchange rates. Differential rates were used to hold down the cost of foreign exchange for most imports, again with the dominant goal of holding down inflation, while higher prices of foreign exchange were paid to exporters to protect their incentives to export. The Central Bank thus paid more for the foreign exchange it bought than it received for the exchange it sold.

The term used for these leakages--for extensions of Central Bank credit that did not count in the government's budget deficit--is the "quasi-fiscal deficit." Its total increased from about 2 percent of GDP in 1985 to about 4 percent in 1987. Meanwhile, the government's tax revenue fell steadily in real terms, partly because of tax reductions implemented to hold down business costs and partly because of the effect of inflation in cutting down the real value of tax payments. Added together, the fiscal deficit plus the quasi-fiscal deficit increased from 5 percent of GDP in 1985 to 11 percent by 1987.

The two horsemen of this particular apocalypse--the external deficit and the swift rise of Central Bank credit--would have made 1988 a bad year no matter what else happened. But President García guaranteed financial disaster by his totally unexpected decision in July 1987 to nationalize the banks not already under government ownership. No one has yet been able to explain why he decided to do so. It would not seem to have been a move necessary for any component of his program, or needed for government control in a banking sector in which it already had a dominant position. In any case, the action underlined the unilateral character of economic policy action under Peru's presidential system and wrecked any possibilities of further cooperation with private sector leadership. Private investment began to fall, and the whole economy followed it down shortly thereafter.

The García government tried a series of major and minor new policy packages from early 1988 into 1990 to no avail. The new policies never succeeded in shutting off the rapid infusion of Central Bank credit that was feeding inflation, even when they did succeed in driving production down significantly in 1989. Manufacturing production fell 18 percent in that year, agricultural output 3 percent, and total GDP 11 percent. Simultaneously, inflation increased from a record 666 percent in 1988 to a new record of 3,399 percent for 1989. The one positive change was the external current-account deficit: the fall in domestic production and income was so steep that the current account went from a deep deficit to a substantial surplus. The internal cost was perhaps clearest in terms of real wages: the minimum wage in real terms for urban labor fell 61 percent between 1987 and 1989, and average real wages in manufacturing fell 59 percent.


Peru - The Fujimori Government


The Fujimori administration began with yet another reversal of practically all the economic policies of the preceding government, in conditions that clearly required drastic corrective action. Its main immediate target was to stop the runaway course of inflation. Beyond that, the goals included repudiating protection and import substitution, returning to full participation in the world trading and financial systems, eliminating domestic price controls and subsidies, raising public revenue and holding government spending strictly to the levels of current revenue, initiating a social emergency program to reduce the shock of adjustment for the poor, and devoting a higher share of the country's resources to rural investment and correction of the causes of rural poverty. In practice, new measures came out in bits and pieces, dominated by immediate concern to stop inflation; actions taken in the first year did not complete the program.

Preoccupation with inflation was natural enough, after the steep rise of 1989 and the months immediately preceding the change of government. The monthly rate of inflation ranged between 25 percent and 32 percent in the second half of 1989, exceeded 40 percent in June 1990, and amounted to 78 percent by July. The deficit of the central government increased from 4 percent of GDP in January 1990 to 9 percent by May. The money supply of the country increased six times over from January to the end of July. The new government had to act quickly, and did.

The most dramatic immediate action was to eliminate price controls for private-sector products and to raise prices of public-sector products to restore financial balance for public firms. The price of gasoline, previously driven down to the equivalent of twelve United States cents a gallon, was multiplied by thirty times. For the consumer price index (CPI), the shocks caused an increase of 136 percent in one day.

Eliminating price controls in the private sector and raising prices charged by state firms had three objectives. First, the price increases for the public-sector firms and government services were meant to restore revenue to a level that would allow the government to stop borrowing from the Central Bank. Second, the rise in prices was intended to reduce aggregate demand by cutting the liquidity of business and the purchasing power of the public. Third, with everything priced far higher relative to public purchasing power, it was expected that market forces would begin to operate to drive some prices back down, reversing the long trend of increases in order to help break the grip of inflationary expectations.

To back up the impact of the price shocks, the government declared that it would keep its own expenditure within the limit of current revenue and stop the other two large streams of Central Bank credit creation: Central Bank financing for agricultural credit and for the system of subsidies supporting differential exchange rates. The multiple exchange rates in effect under García were to be unified, and the unified rate was to be determined by market forces. Further, competition from imports to restrain inflation and access to imported supplies for production would both be improved by taking away quantitative restrictions and reducing tariff rates.

The new policies helped greatly to bring down the rate of inflation, although they fell short of accomplishing full stabilization. Against an inflation rate that had reached approximately 2,300 percent for the twelve months to June 1990, the rate of 139 percent for the twelve months to December 1991 can be seen as a dramatic improvement. But the latter was still more than double the government's intended ceiling for 1991 and still extremely high relative to outside world rates of inflation. The last quarter of 1991 looked more promising, with the monthly rate down to 4 percent, but it had risen to 7 percent by March 1992. Inflationary dangers clearly remained troublesome, especially in view of two factors that should have stopped inflation more decisively: a deeply depressed level of domestic demand and an unintended increase in the real exchange rate, making dollars cheaper.

Domestic demand has been held down by the combination of the price shock at the start of the stabilization program, steeply falling real wages, reduced government deficits, and much tighter restraint of credit. All these were deliberate measures to stop inflation, accepting the likely costs of higher unemployment and restraint of production as necessary to that end. In 1990 GNP fell 3.9 percent, aggravating the plunge of 19 percent between 1988 and 1990. In 1991 production turned up slightly, with a gain of 2.9 percent in GNP. That situation left output per capita essentially unchanged from 1990 and at 29 percent below its level a decade earlier.

The incomplete success in stopping inflation created an extremely difficult policy conflict. Recovery could in principle be stimulated by more expansionary credit policies and lower interest rates, which would favor increased investment, depreciation of the currency to help producers compete against imports, and improved exports. But continuing inflation and the fear of accelerating its rate of increase argued instead for keeping a very tight rein on credit and thereby blocked the actions needed for recovery. This conflict became particularly acute over the question of what to do about the exchange note: the real exchange rate went in exactly the wrong direction for recovery by appreciating when depreciation was both expected and needed.

The decision to remove controls on the exchange rate had been expected to lead to a much higher foreign-exchange price, to encourage exports, and to permit import liberalization without a surging external deficit. But when the rate was set free, the price of dollars went down instead of going up. That initial effect could be explained by the tight restraints imposed on liquidity, which drove firms and individuals who held dollar balances to convert them to domestic currency in order to keep operating. This movement should presumably have gone into reverse when holdings of dollars ran out, but fully eighteen months later no reversal had occurred. Dollars remained too cheap to make exports profitable and too cheap for many producers to compete against imports for several reasons, including the continuing influx of dollars from the drug trade into street markets and then into the banking system. A second reason has involved the continuing low level of domestic income and production, and corresponding restraint of demand for imports as compared with what they would be in an expanding economy. But perhaps the most fundamental reasons have been the continuing squeeze on liquidity in terms of domestic currency and the resulting high rates of interest for borrowing domestic currency, which strongly favor borrowing dollars instead or repatriating them from abroad. All this means that the economy has had no foreign-exchange problem, but also that incentives to produce for export have been held down severely, when both near-term recovery and longer-term growth badly need the stimulus of rising exports.

The government was more successful in the part of its program aimed at trade liberalization. As has been noted, the average tariff rate was cut greatly in two steps, in September 1990 and March 1991. Quantitative restrictions were eliminated, and the tariff structure was greatly simplified. Effective protection was brought down to a lower level than at any point since the mid1960s , with a more coherent structure that left much less room for distorted incentives.

Although stabilization and structural reform measures have thus shown some success, the government's program has not taken adequate action to prevent worsening poverty. Its announced programs of short-term aid in providing food and longer-term redirection of resources to get people out of poverty by programs designed to help them raise their productivity have not yet been implemented in any meaningful way. Private charitable agencies, the United Nations (UN), and the United States Agency for International Development (AID) have helped considerably through food grants to stave off starvation. But the government itself has done little, either to alleviate current strains on the poor or to open up new directions that promise gains for them in the future.


CITATION: Federal Research Division of the Library of Congress. The Country Studies Series. Published 1988-1999.

Please note: This text comes from the Country Studies Program, formerly the Army Area Handbook Program. The Country Studies Series presents a description and analysis of the historical setting and the social, economic, political, and national security systems and institutions of countries throughout the world.

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